Fiscal stimulus in times of low interest rates

It is common knowledge among economists though not always with investors that fiscal stimulus is more effective when the economy is in recession than when it is growing. The fiscal multiplier that measures the change in GDP for every dollar spent by the government tends to be below 1 in boom times and above 1 in recessions. In other words, additional government spending in boom times tends to be a wasteful exercise where some of the government spending does not enhance economic growth. But in a recession, government spending significantly boosts economic growth and accelerates the recovery from the depths of the recession. That is why I am very much in favour of the government stimulus programmes enacted during the pandemic. Governments were doing the right thing at the right time.

But a new study by the IMF indicates that the fiscal multiplier of government spending may not only be higher than normal during a recession but also in boom times when economic growth is larger than the level of interest rates. Looking at 10 countries in the Eurozone, they estimated fiscal multipliers for two different regimes. Instead of the usual recession/boom split, they used the difference between real short-term interest rates and real potential economic growth (the famous r-g) as a differentiating factor.

If the real interest rate is lower than the real potential economic growth (i.e. r-g<0) then additional fiscal spending may lead to additional budget deficits, but because growth exceeds real interest rates, there might not be the need to increase government revenues (read ‘taxes’) in the future to pay for today’s spending spree. Higher growth, in this case, may lead to higher tax revenues that outpace the higher interest expenses from the additional spending. Note, that in the Eurozone, we have been in this regime since the financial crisis of 2008 and in the United States and the UK, we are currently definitely in this regime.

If, on the other hand, real interest rates are higher than real potential growth, additional spending causes a larger increase in interest cost than can be made up by higher tax income from higher growth. In this case, it is pretty likely that at some point in the future, the government will have to increase revenues to pay for the spending of today. This is the regime that the United States, the UK, and Europe were in throughout much of the post-WW2 period and it is what still determines the mental models of many investors.

Businesses and households who understand that the government cannot spend forever, but at some point, have to pay for its debt will take that into account when deciding how much money to save or spend. And if they think that the government will eventually have to increase taxes to pay for current spending (i.e. the second case of r-g>0) then they will ever so slightly increase their savings and reduce consumption and investments. The result is that government spending to incentivise businesses to invest or to incentivise consumers to spend may be less effective.

But in an environment when interest rates are low (i.e. the case of r-g<0 prevalent today), businesses and consumers are less incentivised to save and at the same time less reluctant to spend because they grasp that governments can afford to spend more due to lower cost of debt. So why save some of your income to pay for higher taxes that may never come?

The result is that in a low-interest rate environment, fiscal multipliers for government spending are not only larger than 1, but they tend to grow larger over time. In other words, as more and more people realise that the government won’t need to enact austerity measures to rein in debt, they start to spend and invest more and more, thus making government incentives like child tax credits, government grants for research and development or government infrastructure investments even more effective and powerful. At least in the Eurozone, where we now have ten years of experience, this is what happened and it seems likely to me that a similar effect will take hold in the UK and the United States in coming years.

Fiscal multiplier depending on the level of interest rates vs. growth

Source: IMF